Episode 58: What the Rates Market is Telling Us
Tad Nygren, Head of Government and Agencies, joins the podcast to provide his perspective on the Fed’s recent move to cut interest rates. He discusses the potential impacts of Fed policy on the bond market and what they may expect during the easing cycle.
This transcript is computer-generated and may contain inaccuracies.
Jay Diamond: Hi everybody and welcome to Macro Markets with Guggenheim Investments, where we invite leaders from our investment team to offer their analysis of the investment landscape and the economic outlook. I'm Jay Diamond, head of thought leadership for Guggenheim Investments, and I'll be hosting today. Now, in a widely anticipated move, the Federal Reserve kicked off its easing cycle last month with a 50 basis point cut in the policy rate and indicated that it's shifting its focus away from inflation on to the weakening labor market. The upside surprise from the September jobs report, however, means there's still a lot of uncertainty about what may come next with the economy and Fed policy. Turning points in monetary policy such as these reverberate through the Treasury yield curve. And because the pricing of credit risk is expressed as a spread over the risk free rate, the whole fixed income market is watching the rates market. Here to provide perspective on the potential impacts of Fed policy on the bond markets and what we might expect over the easing cycle, we are joined today by Tad Nygren, head of Guggenheim’s government and agencies desk. Welcome, Tad, and thanks for taking the time to chat with us today.
Tad Nygren: Thank you. It's great to be here with you today to discuss the rates market.
Jay Diamond: Let's get started. Some of us listening might not be familiar with the rates market. Can you tell us what it is exactly?
Tad Nygren: At the highest level, we think of the rates market as the US Treasury market and the associated costs that it implies for the US government to borrow at different maturity points along the Treasury market curve. Treasury market yields at these different points across the maturity spectrum are what the market refers to as the Treasury yield curve. Treasury yields, as you mentioned earlier, are used as a risk free asset across all financial markets since they are backed by the full faith and credit of the US government. And most other credit based, fixed income securities are priced at some incremental yield pick-up versus US Treasury securities. Obviously there are many different factors that can determine the absolute yields of Treasurys across the curve, but at a high level, the Federal Reserve’s monetary policy actions and setting of short term interest rates tend to impact short and intermediate maturity Treasury yields most. More macro focused factors, such as GDP growth, inflation, supply and demand dynamics in the Treasury market, tend to drive longer maturity Treasury yields over time.
Jay Diamond: Drilling down a little bit more, what are you focusing on when you're following the rates market on a regular basis?
Tad Nygren: When we're looking at the Treasury market and the rates market on a daily basis, we're most focused on the macro factors that I just alluded to (GDP growth, inflation, supply and demand dynamics in the Treasury market) in addition to current monetary policy and fiscal factors. Combined, these drive our views across the U.S. Treasury market. At different points in the monetary cycle, certain factors tend to influence the Treasury market more than others. For example, as you know, we're currently in an environment where the Federal Reserve is easing monetary policy after a very restrictive stance that was focused on bringing down decades-high inflation. And now that we've come through that phase of the cycle, we're focused on the Fed’s actions to moderate policy and move the federal funds rate toward a more neutral stance. In this environment, we're most focused on labor market data, and really trying to get a feel for whether the job market will moderate enough to allow the Federal Reserve to move its policy towards a more neutral stance, ideally at a gradual pace. So, we think employment market stability is going to be paramount for the Fed to implement gradual continued policy easing over the next 12 to 18 months or so. At the same time, in the back of our minds, but not front and center, is the fiscal situation in the United States. Over the past few years, starting before Covid, the US has run a persistently large budget deficit. And this deficit needs to be financed by the Treasury market. We think that at some point down the road–as has happened in the past– the Treasury market will shift its focus back to how we're going to continue financing these deficits, and whether the Treasury will have to increase coupon sizes in nominal bonds across the curve. The Treasury market's not focused on this currently, but we believe that it likely will in time and this could induce volatility. Once this time comes, we think there will be a renewed focus on the concept of term premium—the incremental yield that Treasury investors require to buy longer maturity and more duration sensitive or interest rate sensitive bonds further out the curve. And we think that once term premium does return to the Treasury market, it could cause longer maturity Treasury security yields to move higher. We don't know when this will happen. But we do think at some point over the next 12 to 24 months we will see an increased focus on deficit financing.
Jay Diamond: Tad, how do rates investments fit into an actively managed fixed income portfolio that approaches the markets the way we do?
Tad Nygren: For the most part, the Treasury securities that we own across our portfolios are used as a duration management tool to help us maintain our overall portfolio yield curve and duration positioning. Within that Treasury portfolio, we actively decide what types of Treasury products we want out to own. We can own nominal coupon paying bonds. We can also own TIPS securities, which are Treasury inflation protected securities, where the performance of that Treasury bond is linked to the Consumer Price Index. We also decide whether we want to own Treasury coupon or principal strips, which are basically Treasury zero coupon bonds. So those offer us an opportunity to add long duration at cheap prices to the long end of the curve. We're also active in agency bonds. We invest in agency bullet securities, agency callable bonds, as well as agency zero coupon securities. We look at agency securities as another very high quality fixed income instrument that can add incremental yield over Treasury bonds. We see this as an efficient way to enhance yield in high quality portfolios.
Jay Diamond: For listeners who might not be familiar, agency securities are corporate debt securities issued by Fannie Mae and Freddie Mac, not their mortgage backed securities.
Tad Nygren: Correct. These are agency debentures. In addition to Fannie Mae and Freddie Mac, Federal Farm Credit Bank is another large issuer as well as Federal Home Loan Banks. They issue agency debentures and not RMBS securities. And that's the sector that our desk is most focused on.
Jay Diamond: Tad, I want to get to your outlook and what you're thinking about the market right now. The macro environment has changed dramatically this year. Where have we come from and how did we get here?
Tad Nygren: It's been an interesting year for Fed policy. The past year has been all about changing market expectations as around Federal Reserve easing. As you know, at the beginning of the year, the market was expecting 150-plus basis points of cumulative easing to happen throughout the course of 2024. The Fed had just completed its last interest rate cycle, bringing the Fed funds rate to the 5.25, 5.5 percent range in July of 2023. And the market was expecting this tightening to slow growth significantly. Inflation was going to decline meaningfully and the Fed would have to aggressively lower short term rates in the beginning of 2024. Well, as it turns out, inflation continued surprising to the upside throughout the first quarter of 2024. Every time we'd get a stronger employment or inflation report, the expected easing would get pushed out further into 2024, and then the total cumulative amount of expected easing was reduced. So 2024 was really about less easing by the Fed as the economy turned out to be much more resilient than most market participants thought. Fast forward to where we are here. Late in the summer and early fall, employment seemed to be slowing and the Federal Reserve appeared concerned about the changing employment outlook. So just last month we had our first actual ease of the cycle, where the Federal Reserve caught most market participants off guard and eased by 50 basis points when the market was expecting 25. Some would argue that the Fed should have lowered rates in July and they didn't so the 50 basis point cut was just a catch up for the 25 that they probably should have done in July and then another 25 in September. But whatever the case may be, we expect them to ease a few more times this year.
Jay Diamond: So, you mentioned the ease and then there was a surprising jobs number last Friday. Tell us how the market reacted to that upside surprise in the jobs market.
Tad Nygren: The September payroll report was stronger than any economist had projected, and the market reaction was swift. Interest rates increased 25 to 50 basis points across all maturities on the Treasury yield curve in the week after that report. Short-end interest rates—in the 2- to 3-year part of the curve which is most sensitive to Fed policy—increased the most. That reshaping of the yield curve where short term interest rates increased much more than longer term interest rates is what we call a bear flattening of the curve. The other big change that we saw was in the so-called terminal rate. Prior to the September jobs report, the market was pricing that the Federal Reserve would end its easing campaign, or end up at the terminal rate, just a little bit below 3 percent. And after the strong employment report and revisions higher to prior months, we've seen the market reprice that terminal rate higher, around 3.25 and 3.375 percent currently. That was also big driver drove of the move higher in front end Treasury yields. So, it was a very swift, strong move across the Treasury market. It caught a lot of people off guard. The result is that we’ve revised the Federal Reserve's terminal rate higher and also priced in a slower easing pace over the next 12 to 18 months.
Jay Diamond: What was the reaction to today's CPI release?
Tad Nygren: Yields had already moved so much higher in the front end of the curve that we didn't see much movement there. We are seeing a slight steepening in the yield curve today. So front end yields are actually a couple of basis points lower in yield and then longer maturity Treasury yields are a couple basis points higher. But it hasn't been a significant move, at least not compared to what we saw after the September jobs report.
Jay Diamond: So Tad, with all that you've just described, what is our macro view right now?
Tad Nygren: At this point our macro call, which is close to what the market is pricing in, is for two additional 25 basis point cuts in 2024. We have two Fed meetings left, one in November and one in December. And we're expecting a 25 basis point cut at each of those meetings, which is basically what the market is pricing. Looking further into 2025, we expect an additional four 25 basis point cuts at a quarterly pace. So we’re anticipating a cumulative 150 basis points of cuts between now and the end of 2025 and as it currently stands, we think the Federal Reserve will reach its neutral or terminal rate for this easing cycle by the end of 2025, right around the 3.25 percent range for the federal funds rate.
Jay Diamond: But as they say, this is all data dependent.
Tad Nygren: 100 percent. And as we talked about earlier, we saw in 2024 how quickly fed pricing can change over the course of the year. But that's our market call right now.
Jay Diamond: So Tad sitting in your seats, where are you and your team finding value in the rates market?
Tad Nygren: Entering an easing cycle tends to favor a steepening yield curve in your portfolio. So we believe securities at the front end of the yield curve are going to outperform longer maturity treasuries. In turn, we're looking for different ways to position our portfolio to implement that view. Also, as inflation still runs higher than the Fed's target, and their focus shifts to the employment side of their dual mandate, we favor TIPS, or Treasury inflation protected securities. We see interesting opportunities across varying maturities in the TIPS market that we've been looking to opportunistically take advantage of. One of the metrics the market really focuses on when looking at TIPS securities is the concept of break-even rates. If you think of a nominal ten year treasury, which is the ten year yield that you see quoted everywhere, the ten year TIPS security also has a yield which is referred to as the real yield. And taking that nominal ten year yield, minus the real yield of the TIPS security, gives you the market's implied break even inflation rate. That's the market's best guess at inflation expectations over that period. Now ten year break even inflation rates are around 230 basis point. That's telling you that on average the market thinks inflation CPI is going to average 2.3 percent over the next ten years. They were much cheaper than this not long ago. We still think there's value in the 10 year TIPS, but we watch the break-even rates across different tenors in TIPS and look for opportunities there as well.
Jay Diamond: And Tad, I note that the ten year Treasury is backed up. It's now above 4 percent again. I don't want to hold you to a forecast here, but what do you expect the trading range will be for the ten year Treasury and the two year Treasury, at least over the near term.
Tad Nygren: It’s tough to put a number on those. But right now we feel that we are in a trading range at the front end of the yield curve for the two year and for the ten year as well. Given where we've started the easing cycle and where we think it’s going to end, we think that the two year is likely to trade in a 3.5 to 4 percent range. Amid the backup in yield that we've had following the September jobs report, we do think that there's decent value in two year notes trading around 4 percent. The ten year as well is in a trading range, in our view, from probably 3.75 to 4.25 over the shorter term. We've broken above 4 percent here following the jobs report, and we think there's potentially a little bit more upside in ten year Treasury yields. But we think they'll be rangebound.
Jay Diamond: Tad, I have to thank you again for taking the time to speak with us today on a busy data filled day. But, before I let you go, I have to ask, as a final takeaway for our listeners, could summarize what the rates market is telling us about the future?
Tad Nygren: I think that the rates market is telling us that the Federal Reserve has begun on an easing campaign. We expect that they're going to continue to lower interest rates, likely in 25 basis point increments, over the next 12 to 18 months. At the same time, we think that Treasury yields that are still at relatively attractive levels across the yield curve. And we feel that now is a is a great time to be invested in fixed income.
Jay Diamond: Thank you, Tad, and thanks again for your time today.
Tad Nygren: Thanks, Jay I really enjoyed it.
Jay Diamond: And thanks to all of you who have joined us for our podcast. If you like what you are hearing, please rate us five stars. And if you have any questions for Tad or any of our other podcast guests, please send them to macromarkets@guggenheiminvestments.com, and we will do our best to answer them on a future episode or offline. I'm Jay Diamond and we look forward to gathering again for the next episode of Macro Markets with Guggenheim Investments. In the meantime, for more of our thought leadership, please visit us at guggenheiminvestments.com/perspectives. So long.
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